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Last Word: Investment cycle linked to economy

Jeffrey J. Cohen | Feb 01, 2001

The election of George W. Bush as the 43rd president of the United States certainly changes the political landscape in Washington, D.C. But if history proves anything, the result of the presidential race will have no bearing on the real estate market for institutional investors. As always, the laws of supply and demand will dictate how the real estate market performs.

Over the past decade, the economy performed well beyond expectation, yielding high rates of return for stock market investors and single-family home buyers. The institutional real estate investor, however, did not realize the same rates of return. Why not? As the economy burned hot, so too did the institutional real estate market. This super-heated market changed the dynamics for investors in a relatively short period of time. Properties sold at bottom-market prices 10 years ago now command premium prices. Today, the market has climbed so high that prices have surpassed the point where strong returns on large properties, in particular large residential properties, are feasible.

The prosperous economy is to blame regarding this altered real estate investment landscape. In the early 1990s, the after effects of recession, the wholesale sell-off of properties by the Resolution Trust Corp., and the continued abandonment of inner cities by the upper-middle class created a glut of cheap and desirable properties for savvy investors.

Consumer appetite for urban residential real estate exploded during the '90s, thanks to lifestyle changes driven by the economy. Young professionals flush with dot.com dollars and empty nesters enriched by the sale of suburban homes returned to cities in droves. Once there, these consumers demanded luxury units, with an emphasis on amenities and service. Urban areas such as Boston, New York City, Washington, D.C., Atlanta, Miami, Philadelphia and Chicago all experienced an influx of residents looking for cultured experience found in revitalized and reinvigorated cities who were willing to shell out sizable amounts of money on rent.

The well-heeled migration boosted rents in residential properties, and as rents rose, so too did property values. The overabundance of demand stands in stark contrast to the 1980s, when the crush of overbuilding and condo conversions created too much supply and drove real estate prices down. The value in urban areas rose in tandem with the world's stock markets, notably the tech-heavy NASDAQ, which experienced an enormous surge in value over the past five years. This growth buoyed portfolio funds for small investors and pension funds managers alike, as the markets bulged with profit. These increases ultimately had a dramatic effect on real estate markets.

The reason for this is found in the makeup on institutional real estate investment portfolios. Typically, real estate represents approximately 5% of an institutional investment portfolio. Huge returns from the stock market, however, increase the portfolio's value as well as the amount of available free cash. Thus when the so-called dot.com economy inflated the value of investment portfolios over the past five years, the traditional 5% allotment for real estate shrunk as a percentage of overall value. To remedy this imbalance, money managers had no choice but to allocate a greater percentage of available capital for real estate, even if that meant accepting a lower rate of return of those investments.

With the market now at its highest point, the typical return on institutional real estate is comparable with safe, low-yield investments such as Treasury bills. These investments make sense for managers of enormous pension funds who need to park vast quantities of capital without worrying about rates of return. For the serious real estate investor, this excess of capital in the market poses a serious challenge: how to find investments that can yield the industry standard of 10% in returns on the initial investment?

The recent corrections in the Dow and NASDAQ markets may be an indicator of a coming correction in the super-heated real estate market. Should that prove true, pension funds and money managers may sell real estate holdings in search of bigger profits. Or, perhaps, a collapse or consolidation of dot.com companies will fuel an increase in residential vacancies and thereby lead to a decline in real estate values.

Supply may be short, but this will change if existing prices drop. For example, commercial space in the high-demand, short-supply market of downtown Boston rents at $100 per sq. ft. This sum may prove difficult to sustain given the less expensive office space available in nearby suburbs. If companies doing business in the city are forced to tighten their belts, they may have no choice but to relocate, thereby reducing demand while increasing supply.

For now, the reality of institutional real estate investment remains the same. Smaller players must hunt for more aggressive deals and assume greater risk, even as those deals are increasingly difficult to find. With the stock markets in flux, sharp real estate investors will look for economic indicators showing a slowdown or downturn in the economy. This type of trend - certainly not election results - will usher in the next strong real estate investment cycle.